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Identify the choice that best completes the statement or answers the question.
____ 1. If 10-year T-bonds have a yield of 5.2%, 10-year corporate bonds yield 7.5%, the maturity risk premium on all 10-year bonds is 1.1%, and corporate bonds have a 0.2% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond?
a. 1.00%
b. 1.10%
c. 1.20%
d. 1.30%
e. 1.40%
____ 2. The real risk-free rate is 3%, inflation is expected to be 2% this year, and the maturity risk premium is zero. Ignoring any cross-product terms, what is the equilibrium rate of return on a 1-year Treasury bond?
a. 4.90%
b. 5.00%
c. 5.10%
d. 5.20%
e. 5.30%
____ 3. Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bond is 6.0%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.4% for a 2-year bond. What is the equilibrium market forecast for 1-year rates 1 year from now?
a. 6.28%
b. 6.39%
c. 6.50%
d. 6.61%
e. 6.72%
For number 3, the correct answer is 6.20%, the correct answer is not among the choices
____ 4. Assume the following: The real risk-free rate, r*, is expected to remain constant at 3%. Inflation is expected to be 3% next year and then to be constant at 2% a year thereafter. The maturity risk premium is zero. Given this information, which of the following statements is CORRECT?
a. The yield curve for U.S. Treasury securities will be upward sloping.
b. A 5-year corporate bond will have a lower yield than a 5-year Treasury security.
c. A 5-year corporate bond will have a lower yield than a 7-year Treasury security.
d. The real risk-free rate cannot be constant if inflation is not expected to remain constant.
e. This problem’s assumption of a zero maturity risk premium is probably not valid in the real world.
____ 5. Assume that the rate on a 1-year bond is now 6%, but all investors in the market expect 1-year rates to be 7% one year from now and then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. Which of the following statements is CORRECT?
a. The yield curve would be downward sloping, with the rate on a 1-year bond at 6%.
b. The interest rate today on a 2-year bond would be 6%.
c. The interest rate today on a 2-year bond would be 7%.
d. The interest rate today on a 3-year bond would be 7%.
e. The interest rate today on a 3-year bond would be 8%.
____ 6. If the pure expectations theory of the term structure is correct, which of the following statements is CORRECT?
a. An upward sloping yield curve would imply that interest rates are expected to be lower in the future.
b. If a 1-year Treasury bill has a yield to maturity of 7% and a 2-year Treasury bill has a yield to maturity of 8%, this would imply the market believes that 1-year rates will be 7.5% one year from now.
c. The yield on a 5-year corporate bond should always exceed the yield on a 3-year Treasury bond.
d. Interest rate price risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds.
e. Interest rate price risk is higher on short-term bonds, but reinvestment rate risk is higher on long-term bonds.
____ 7. Which of the following is CORRECT?
a. Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve.
b. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds.
c. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted.
d. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve cannot become inverted.
e. The most likely explanation for an inverted yield curve is that investors expect inflation to increase in the future.
____ 8. Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on both Treasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following statements is CORRECT?
a. The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities.
b. The yield on all corporate bonds must exceed the yields on all Treasury bonds.
c. The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds.
d. The stated conditions cannot all be true?they are internally inconsistent.
e. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.
____ 9. Three-year treasury securities yield 5%, 5-year treasury securities yield 6%, and 8-year treasury securities yield 7%. If the expectations theory is correct, what is the expected yield on 5-year Treasury securities three years from now?
a. 5.09%
b. 7.00%
c. 6.71%
d. 8.22%
e. 6.03%
____ 10. You read in The Wall Street Journal that 30-day T-bills are currently yielding 8%. Your brother-in-law, a broker at Kyoto Securities, has given you the following estimates of current interest rate premiums:
• Inflation premium ? 5%.
• Liquidity premium ? 1%.
• Maturity risk premium ? 2%.
• Default risk premium ? 2%.
Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. On the basis of these data, the real risk-free rate of return is
a. 0%
b. 1%
c. 2%
d. 3%
e. 4%
____ 11. A 5-year corporate bond has an 8% yield. A 10-year corporate bond has a 9% yield. The two bonds have the same default risk premium and liquidity premium. The real risk-free rate, r*, is expected to remain constant at 3%. Inflation is expected to be 3% a year for the next five years. After five years, inflation is expected to be constant at some rate, X, which may or may not be 3%. The maturity risk premium equals 0.1%(t ? 1), where t equals time until the bond’s maturity. What is the market’s expectation today of the average level of inflation for Years 6 through 10, that is, what is X? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
a. 4.0%
b. 6.0%
c. 1.5%
d. 0.9%
e. 7.0%
____ 12. Assume that today is January 1, 2006. A 5-year corporate bond maturing on January 1, 2011, has a yield to maturity of 7.5%. A 10-year corporate bond maturing on January 1, 2016, with the same liquidity and default risk premiums as the 5-year corporate bond has a yield to maturity of 8.2%. The annual real risk-free rate, r*, is expected to remain constant at 2%. The maturity risk premium equals 0.1%(t ? 1), where t ? the bond’s maturity in years. Inflation is expected to average 2% per year for the next five years. What is the average annual expected inflation between January 2008 and January 2013? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
a. 2.2%
b. 0.2%
c. 3.4%
d. 0.6%
e. 2.4%
____ 13. The interest rate on Treasury securities that mature in four years is 8%. What is expected inflation in Year 4?
a. 3.0%
b. 5.0%
c. 6.0%
d. 7.0%
e. 8.0%
____ 14. A 12-year bond has an annual coupon rate of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT?
a. The bond is currently selling at a price below its par value.
b. If market interest rates decline, the price of the bond will also decline.
c. If market interest rates remain unchanged, the bond’s price one year from now will be lower than it is today.
d. If market interest rates remain unchanged, the bond’s price one year from now will be higher than it is today.
e. The bond should currently be selling at its par value.
____ 15. An investor is considering buying one of two 10-year, $1,000 face value bonds: Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, which is expected to remain constant for the next 10 years. Which of the following statements is CORRECT?
a. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price as each other.
b. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price as each other.
c. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature.
d. One year from now, Bond A’s price will be higher than it is today.
e. Bond A’s current yield is greater than 8%.
____ 16. Which of the following statements is CORRECT?
a. All else equal, a bond that has a coupon rate of 10% will sell at a discount if the required return for bonds of similar risk is 8%.
b. The price of a discount bond will increase over time, assuming that the bond’s yield to maturity remains constant over time.
c. The total return on a bond for a given year consists only of the coupon interest payments received.
d. When large firms are in financial distress, they are almost always liquidated, whereas smaller firms are generally reorganized.
e. For a given firm, its debentures are likely to have a lower yield to maturity relative to its mortgage bonds.
____ 17. Which of the following statements is INCORRECT about bonds? In all of the statements, assume other things are held constant.
a. Price sensitivity, that is, the change in price due to a given change in the required rate of return, increases as a bond’s maturity increases.
b. For a given bond of any maturity, a given percentage point increase in the interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from an identical decrease in the interest rate.
c. For any given maturity, a given percentage point increase in the interest rate causes a smaller dollar capital loss than the capital gain stemming from an identical decrease in the interest rate.
d. From a borrower’s point of view, interest paid on bonds is tax-deductible.
e. A 20-year zero coupon bond has less reinvestment rate risk than a 20-year coupon bond.
____ 18. Which of the following statements is CORRECT?
a. A 10-year bond would have more interest rate risk than a 5-year bond, but all 10-year bonds have the same interest rate risk.
b. A 10-year bond would have more reinvestment rate risk than a 5-year bond, but all 10-year bonds have the same reinvestment rate risk.
c. If their maturities and other characteristics were the same, a 5% coupon bond would have more interest rate risk than a 10% coupon bond.
d. If their maturities and other characteristics were the same, a 5% coupon bond would have less interest rate risk than a 10% coupon bond.
e. Any zero coupon bond will have more interest rate price risk than any other type bond, even a perpetuity.
____ 19. Assume that a 15-year, $1,000 face value bond pays interest of $37.50 every 3 months. If you require a nominal annual rate of return of 12%, with quarterly compounding, how much should you be willing to pay for this bond?
a. $ 821.92
b. $1,207.57
c. $ 986.43
d. $1,120.71
e. $1,358.24
____ 20. You just purchased a $1,000 par value, 9-year, 7% semiannual coupon bond. The bond sells for $920. What is the nominal yield to maturity?
a. 7.28%
b. 8.28%
c. 9.60%
d. 8.67%
e. 4.13%
____ 21. Cold Boxes Ltd. has 100 bonds outstanding (maturity value ? $1,000). Their nominal required yield to maturity is 10%, and interest is paid semiannually. The bonds mature in 5 years, and their current market value is $768 per bond. What is the annual coupon interest rate?
a. 8%
b. 6%
c. 4%
d. 2%
e. 0%
____ 22. The current price of a 10-year, $1,000 par value bond is $1,158.91. Interest on this bond is paid every six months, and the nominal annual yield is 14%. Given these facts, what is the annual coupon rate on this bond?
a. 10%
b. 12%
c. 14%
d. 17%
e. 21%
____ 23. A 6-year bond, 8% semiannual coupon bond sells at par ($1,000). Another bond of equal risk, maturity, and par value pays an 8% annual coupon. What is the price of the annual coupon bond?
a. $689.08
b. $712.05
c. $980.43
d. $986.72
e. $992.64
____ 24. A 15-year, 10% semiannual coupon bond has a par value of $1,000. The bond has a nominal yield to call of 6.5%, but may be called after 10 years at a price of $1,050. What is the bond’s nominal yield to maturity?
a. 5.97%
b. 6.30%
c. 6.75%
d. 6.95%
e. 7.10%
____ 25. Recently, Ohio Hospitals Inc. filed for bankruptcy. The firm was reorganized as American Hospitals Inc., and the court permitted a new indenture on an outstanding bond issue to be put into effect. The issue has 10 years to maturity and an annual coupon rate of 10%. The new agreement allows the firm to pay no interest for 5 years. Then, interest payments will be resumed for the next 5 years. Finally, at maturity (Year 10), the principal plus the interest that was not paid during the first 5 years will be paid. However, no interest will be paid on the deferred interest. If the required annual return is 20%, what should the bonds sell for in the market today?
a. $242.26
b. $281.69
c. $578.31
d. $362.44
e. $813.69
____ 26. T. Martell Inc.’s stock has a 50% chance of producing a 30% return, a 25% chance of producing a 9% return, and a 25% chance of producing a -25% return. What is Martell’s expected return?
a. 14.4%
b. 15.2%
c. 16.0%
d. 16.8%
e. 17.6%
____ 27. Niendorf Corporation’s stock has a required return of 13.00%, the risk-free rate is 7.00%, and the market risk premium is 4.00%. Now suppose there is a shift in investor risk aversion, and the market risk premium increases by 2.00%. What is Niendorf’s new required return?
a. 14.00%
b. 15.00%
c. 16.00%
d. 17.00%
e. 18.00%
____ 28. Suppose you hold a diversified portfolio consisting of $10,000 invested equally in each of 10 different common stocks. The portfolio’s beta is 1.120. Now suppose you decided to sell one of your stocks that has a beta of 1.000 and to use the proceeds to buy a replacement stock with a beta of 1.750. What would the portfolio’s new beta be?
a. 0.982
b. 1.017
c. 1.195
d. 1.246
e. 1.519
____ 29. Assume that the risk-free rate is 5%. Which of the following statements is correct?
a. If a stock’s beta doubled, its required return would also double.
b. If a stock’s beta doubled, its required return would more than double.
c. If a stock’s beta were 1.0, its required return would be 5%.
d. If a stock’s beta were less than 1.0, its required return would be less than 5%.
e. If a stock has a negative beta, its required return would be less than 5%.
____ 30. Which of the following statements is CORRECT?
a. If a company’s beta doubles, then its required rate of return will also double.
b. If investors became more risk averse, then the slope of the security market line should decrease.
c. If a company’s beta is cut in half, then its required rate of return will also be halved.
d. Other things held constant, if investors suddenly became convinced that there would be deflation in the economy, then the required returns on all stocks should decrease.
e. If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rates of return on stocks with betas less than average will decline while returns on stocks with above average betas will increase.
____ 31. The risk-free rate, rRF, is 6%. The overall stock market has an expected return of 12%. Hazlett, Inc. has a beta of 1.2. What is the required return of Hazlett, Inc. stock?
a. 12.0%
b. 12.2%
c. 12.8%
d. 13.2%
e. 13.5%
____ 32. A stock has a required return of 12.25%. The beta of the stock is 1.15 and the risk-free rate is 5%. What is the market risk premium?
a. 1.30%
b. 6.50%
c. 15.00%
d. 6.30%
e. 7.25%
____ 33. Partridge Plastic’s stock has an estimated beta of 1.4, and its required return is 13%. Cleaver Motors’ stock has a beta of 0.8, and the risk-free rate is 6%. What is the required return on Cleaver Motors’ stock?
a. 7.0%
b. 10.4%
c. 12.0%
d. 11.0%
e. 10.0%
____ 34. Hahn Manufacturing is expected to pay a dividend of $1.00 per share at the end of the year (D1 ? $1.00). The stock sells for $40 per share, and its required rate of return is 11%. The dividend is expected to grow at a constant rate, g, forever. What is Hahn’s expected growth rate?
a. 8.00%
b. 8.50%
c. 9.00%
d. 9.50%
e. 10.00%
____ 35. The Ehrhardt Company’s last dividend was $2.00. The dividend growth rate is expected to be constant at 3% for 2 years, after which dividends are expected to grow at a rate of 8% forever. Erhardt’s required return (rs) is 12%. What is Erhardt’s current stock price?
a. $49.20
b. $51.40
c. $53.80
d. $55.10
e. $57.30
____ 36. If a stock’s expected return exceeds its required return, this suggests that
a. The stock is experiencing supernormal growth.
b. The stock should be sold.
c. The company is probably not trying to maximize price per share.
d. The stock is probably a good buy.
e. Dividends are not being declared.
____ 37. If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT?
a. The expected return on the stock is 5% a year.
b. The stock’s dividend yield is 5%.
c. The stock’s price one year from now is expected to be 5% higher.
d. The stock’s required return must be equal to or less than 5%.
e. The price of the stock is expected to decline in the future.
____ 38. Which of the following statements is CORRECT?
a. If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but the two classes must have the same voting rights.
b. An IPO occurs whenever a company buys back its stock on the open market.
c. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of common stock.
d. The stock valuation model, P0 ? D1/(rs ? g), cannot be used for firms that have negative growth rates.
e. The stock valuation model, P0 ? D1/(rs ? g), can be used only for firms whose growth rates exceed their required return.
____ 39. Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT?
a. All common stocks fall into one of three classes: A, B, and C.
b. All firms have several classes of common stock.
c. All common stocks, regardless of class, must have the same voting rights.
d. All common stock, regardless of class, must pay the same dividend.
e. Some class or classes of common stock may be entitled to more votes per share than other classes.
____ 40. A stock is not expected to pay a dividend over the next four years. Five years from now, the company anticipates that it will establish a dividend of $1.00 per share (i.e., D5 ? $1.00). Once the dividend is established, the market expects that the dividend will grow at a constant rate of 5% per year forever. The risk-free rate is 5%, the company’s beta is 1.2, and the market risk premium is 5%. The required rate of return on the company’s stock is expected to remain constant. What is the current stock price?
a. $ 7.36
b. $ 8.62
c. $ 9.89
d. $10.98
e. $11.53
____ 41. Holmgren Hotels’ stock has a required return of 11%. The stock currently does not pay a dividend but it expects to begin paying a dividend of $1.00 per share starting five years from today (D5 ? $1.00). Once established the dividend is expected to grow by 25% per year for two years, after which time it is expected to grow at a constant rate of 10% per year. What should be Holmgren’s stock price today?
a. $ 84.80
b. $174.34
c. $ 76.60
d. $ 94.13
e. $ 77.27
____ 42. The Hart Mountain Company is expected to experience an unusually high growth rate (20%) during the next 3 years. However, in the fourth year the firm is expected to begin growing at a constant long-term growth rate of 8%. During the rapid growth period, the firm’s dividend payout ratio will be relatively low (20%) in order to conserve funds for reinvestment. However, the decrease in growth in the fourth year will also be accompanied by an increase in the dividend payout to 50%. Last year’s earnings were E0 ? $2.00 per share, and the firm’s required return is 10%. What should be the current price of the common stock?
a. $66.50
b. $87.96
c. $71.54
d. $61.78
e. $93.50
____ 43. Club Auto Parts’ last dividend, D0, was $0.50, and the company expects to experience no growth for the next 2 years. However, Club will grow at an annual rate of 5% in the third and fourth years, and, beginning with the fifth year, it should attain a 10% growth rate that it will sustain thereafter. Club has a required rate of return of 12%. What should be the price per share of Club stock at the end of the second year, ?
a. $19.98
b. $25.08
c. $31.21
d. $19.48
e. $27.55
____ 44. Modular Systems Inc. just paid dividend D0, and it is expecting both earnings and dividends to grow by 0% in Year 2, by 5% in Year 3, and at a rate of 10% in Year 4 and thereafter. The required return on Modular is 15%, and it sells at its equilibrium price, P0 ? $49.87. What is the expected value of the next dividend, D1?
a. It cannot be estimated without more data.
b. $1.35
c. $1.85
d. $2.35
e. $2.85
____ 45. Heino Inc. hired you as a consultant to help them estimate their cost of capital. You have been provided with the following data: rRF ? 5.0%; RPM ? 5.0%; and b ? 1.1. Based on the CAPM approach, what is the cost of equity from retained earnings?
a. 10.50%
b. 10.71%
c. 10.88%
d. 11.03%
e. 11.14%
____ 46. Rhino Inc. hired you as a consultant to help them estimate their cost of capital. You have been provided with the following data: D1 ? $1.30; P0 ? $40.00; and g ? 7% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?
a. 9.66%
b. 9.84%
c. 9.97%
d. 10.08%
e. 10.25%
____ 47. You were hired as a consultant to Locke Company, and you were provided with the following data: Target capital structure: 40% debt, 10% preferred, and 50% common equity. The interest rate on new debt is 7.5%, the yield on the preferred is 7.0%, the cost of retained earnings is 11.50%, and the tax rate is 40%. The firm will not be issuing any new stock. What is the firm’s WACC?
a. 8.25%
b. 8.38%
c. 8.49%
d. 8.61%
e. 8.76%
____ 48. Reingaart Systems is expected to pay a $3.00 dividend at year end (D1 ? $3.00), the dividend is expected to grow at a constant rate of 7% a year, and the common stock currently sells for $60 a share. The before-tax cost of debt is 8%, and the tax rate is 40%. The target capital structure consists of 60% debt and 40% common equity. What is the company’s WACC if all equity is from retained earnings?
a. 7.17%
b. 7.31%
c. 7.45%
d. 7.68%
e. 7.84%
____ 49. The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5% and the market risk premium is 6%. Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget. What is the company’s cost of retained earnings, rs?
a. 7.0%
b. 7.2%
c. 11.0%
d. 12.2%
e. 12.4%
____ 50. Sun State Mining Inc., an all-equity firm, is considering forming a new division that will increase the firm’s assets by 50%. Sun State currently has a required return of 18%, U.S. Treasury bonds yield 7%, and the market risk premium is 5%. If Sun State wants to reduce its required return to 16%, what is the maximum beta coefficient the new division could have?
a. 2.2
b. 1.0
c. 1.8
d. 1.6
e. 2.0